China Costs Start to Worry U.S. Multinationals

For years, low prices on China-sourced goods helped dampen inflation in the United States. Now China's efforts to boost domestic consumer spending, reducing reliance on exports, are leading to higher costs for multinationals that manufacture goods there.

They have plenty of options besides raising prices, such as embracing automation or moving to China's less-developed interior. Some companies relegate China costs to the category of minor headache; others point to long-term benefits from richer Chinese consumers. But the topic has become a talking point during the earnings season now winding down.

"Input cost increases have been a steady headwind to margins for some time now," Fairchild Semiconductor International Chief Financial Officer Mark Frey said last month. "Metals and energy pricing, forex and China wage inflation are more difficult to forecast."

Yum, the No. 1 Western restaurant brand in the world's fastest-growing major economy, generates a third of its profit from China. It said its full-year margins will dip this year, citing labor inflation in the mid-to-high teens.

"I do believe that labor inflation will continue high for quite a while," Yum CFO Rick Carucci said on the company's earnings conference call. He called commodity prices another "wild card" for the company.

GO WEST, YOUNG MAN

Nearly a third of Emerson Electric's total workforce is in China, where it employs more than 40,000 people. Amid 20 percent wage increases, the company has said it could move some production to China's interior, and it might move 20 percent of its capacity to other Asian countries.

"The economy is going into a more costly mode," CEO David Farr said on Emerson's second-quarter conference call. "We are going to have to refix where we're manufacturing."

Emerson's network power business was the only of its five units to show lower operating profits in the latest quarter. The company cited labor inflation among the causes.

"A lot of the wage increase is to keep civil unrest at a minimum," said William Blair analyst Nick Heymann, who said suicides at an Apple supplier and the "Arab Spring" protests have alarmed Beijing. "These guys have watched North Africa and the Middle East with a lot of trepidation."

A related, complicating factor is that local competitors, many state-owned and not too worried about margins, are challenging companies like Emerson on price, Heymann said.

Multinationals have figured out they cannot compete on cost: they must differentiate their products, making them smaller, faster or more energy-efficient. Then, depending on the product, they might be able to ask for higher prices.

Others, such as makers of labor-intensive shoes and toys, have to take into account a cost-conscious consumer now potentially facing a new recession. Still, Hasbro and Mattel have pushed through price increases this year, and Hasbro's CEO has said China remains its preferred manufacturing hub.

MANUFACTURING A CONSUMER CULTURE

China this year adopted a five-year plan that calls for 7 percent growth in per-capita income, ahead of earlier targets, and fresh investment in research and development, to boost domestic consumption and modernize its economy.

Manufacturing wages are a fraction of those in the United States but are narrowing the gap, both fueling and responding to China's inflation, now at three-year highs. Between 1978 and 2009, wages jumped almost 13 percent a year, six times the pace of U.S. wage rises, according to BernsteinResearch.

Since 2006, that growth has accelerated.

By 2015, wages around Shanghai, adjusted for productivity, will be 61 percent of those in low-cost U.S. states like Alabama, according to the Boston Consulting Group (BCG). Transport and other considerations further shrink that gap.

"Wages are getting large enough that you start to feel the difference," said Hal Sirkin, a BCG senior partner, who said U.S. companies are looking at alternative manufacturing sites. "One of the answers is to start moving back to the U.S."

The next few years will bring a wave of reinvestment by U.S. multinational manufacturers in their home base, as rising wages and a strong yuan currency make China a less attractive production center, BCG predicts. Its July BCG paper names 14 companies rethinking where they produce goods, including NCR , Ford, Flextronics , Ashland, and Jarden's Coleman unit.

Where China once had ample labor, and supply was well balanced with demand, that equilibrium has broken down, BCG argues. The change does not mean shutting Chinese factories and firing workers; it means selectively scaling back future expansion or investment. China's size will ensure it remains a major global player.

China's well-developed infrastructure is an advantage over other countries such as the Philippines, Indonesia and Vietnam. And any short-term hit to margins has to be balanced against the long-term opportunity in a richer China. For many producers, costs such as oil and metals are a bigger headache than the soaring cost of labor.

"I'm not that worried about it," Honeywell CEO Dave Cote said, referring to wage inflation. "I don't put it up there in one of these economic perils kind of categories."

Manufacturers including Honeywell are looking inland, where wages are lower, Cote said, or they are automating production.

"You'd look at it in the past and say, instead of a machine, it's worth having 10 people do it," Cote said. "Well, that may not be true anymore."

Cote's comment points to a crucial silver lining for some U.S. companies. If factories invest in machines, that helps Emerson and Rockwell Automation. If China expands its consumer middle class, the Yums of the world benefit as families eat out more or adopt a protein-rich diet.

Ultimately, the success of that drive to shore up China's consumer base may determine how U.S. companies perceive the risks and rewards of operating in China.

"The customer base in China is just so immense," said Tim Hanley, Deloitte LLP U.S. Process & Industrial Products Leader. "Companies that were in China as a low-cost exporting base recognize they need to be there. That's where demand is."

For years, low prices on China-sourced goods helped dampen inflation in the United States. Now China's efforts to boost domestic consumer spending, reducing reliance on exports, are leading to higher costs for multinationals that manufacture goods there.
Eventually, China...